What Happens If The U.S. Avoids Default?

by Alan Zafran

Let’s assume that the government finds a way to avoid a default on August 2nd.

Let’s also assume that this means an increase in the debt ceiling will be forthcoming and that the government will not choose to play musical chairs with prioritizing payments owed to soldiers, Social Security beneficiaries and debt holders in lieu of raising the debt ceiling.

How will the markets react to any government announcement in dealing with this U.S. debt crisis? The answer will depend on four variables:

1. The size of the raise in the debt ceiling in the near-term (a larger raise in the ceiling buys the politicians more time to create a longer-term deficit reduction plan).
2. The size of the “talked about/intended” cuts in the deficit for the longer-term.
3. The speed at which a bipartisan panel will aim to achieve these intended, longer-term cuts in the deficit.
4. Most importantly, the credibility that the market places on their intended longer-term plan to cut the deficit.

Keep these points in mind when anticipating what happens next.

A credible and large (say over $3 trillion) longer-term deficit reduction plan, which is back-end loaded, may be positive for the markets. It could induce rallies in both bond and stock prices as it would demonstrate fiscal resolve, reinvigorate business and consumer confidence, and lower interest rates in the long run that would increase P/E multiples for stocks.

A credible and small plan may help stocks in the short-run (since economic growth would not be materially reduced at first) but could hinder bond prices since the market may feel that there isn’t enough magnitude in addressing the out-of-control deficit problem. It remains uncertain as to how equities will act in this longer-term scenario since the deficit issue will not have been fully addressed and eventually uncertainty about the deficit could hamper consumer and business confidence.

And what happens if any “compromised” plan of action fails to gain credibility? Under such circumstances, interest rates may initially move higher as “bond vigilantes” boycott buying U.S. bonds given the ever-larger deficit. Simultaneously, equities might face the headwinds of higher interest rates and reduced consumer confidence resulting in an even slower rate of economic growth than what currently exists. Ironically, a failure to create a credible plan on the deficit could ultimately lead to lower rates. How? By inducing a loss of confidence in government officials’ ability to address the deficit— consumers and businesses may curtail their spending, which will lead to an economic recession that drives both interest rates and stock prices lower.

Let’s hope that the politicians can act like adults and quickly replace their political ideology with a harsh dose of economic reality.

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